Some
financial decisions should be no-brainers. Yet it's when the
brain gets in the way that things turn most interesting

By Matt Golosinski

How to
minimize risk while maximizing reward is the heart of finance.
In their efforts to break new ground on this subject, Kellogg
School finance professors employ a variety of tools and theories
to conceptualize risk, all of which prove extremely beneficial
for those looking to make smart decisions about capital reallocation,
for instance.

These
frameworks and methodologies include such industry bulwarks
as the capital asset pricing model, real options, agency theory,
portfolio theory and more. Each of these ways of thinking
about risk and reward yields its own special discoveries,
but at root each approach requires researchers to take a close
look at what motivates people to invest or disinvest in practice.

The "in
practice" qualifier is an important one, since from a
Finance I perspective, certain investment decisions ought
to be straightforward, based on fundamental assumptions and
driven by the numbers. Theoretically, some transactions should
be merely the outcome of using the capital asset pricing model
(CAPM, a way of thinking about diversifiable and nondiversifiable
risk) to calculate net present value (NPV, the difference
between the cost of undertaking a project and the expected
returns from that project). In this scenario, the hardest
part may simply be waiting for the earnings statement to reflect
the financial architect's wise, if conventional, choices.

While
some decisions are this obvious, many others are far more
complex, their risks subtle and their outcomes shrouded in
the whims of a volatile market that the finance models try
to keep up with. It is this fact that makes finance so engrossing,
or nerve-wracking, depending upon one's perspective and portfolio.

One idiosyncratic
challenge facing economists, finance scholars, investment
bankers and CFOs is that, unlike many other academic disciplines,
finance works in a more "real-time" relationship with the
marketplace.

"Whether
you are doing macroeconomics, labor economics or finance,
you're sort of stuck with the historical record," says
Robert
Korajczyk, senior associate dean: curriculum and teaching,
and an asset pricing expert.

"You
don't have the luxury that experimental sciences have. There
are some people doing experiments in finance, but there are
issues about whether those experiments with small groups generalize
to a market where you have people competing with one another,"
adds Korajczyk, who is also the Harry G. Guthmann Distinguished
Professor of Finance.

What
is it that keeps capital from moving to the highest productivity
firms, in particular in bad times?" asks Prof. Andrea
Eisfeldt.

Behaviors
apparent in a smallenvironment may not be sustainable in a
larger environment, he points out.

Yet despite
this experimental limitation, Kellogg School finance professors
continue to produce compelling research. Their typical destination?
Into the unknown. After all, it's uncertainty that breeds
risk: the things we don't know can create situations in which
asymmetric information establishes a dynamic where fortunes
are won or lost.

Why
bad managers need a bigger paycheckLarge
severance payments to managers leaving firms are certainly
controversial, but if Andrea
Eisfeldt and Adriano Rampini are correct
in their theories about asset reallocation, those big bonuses
are no mistake.

The Kellogg
School finance professors have been focusing their attention
on the role managerial incentives play in capital budgeting,
in particular, the way managers' preferences influence investment
decisions during both economic booms and downturns.

At the
heart of their recent work is understanding how to get capital
resources —such things as machines, manufacturing plants,
and other physical inputs —into the hands of those firms
that can make the most productive use of them. Too often,
they say, underperforming companies are reluctant to sell
their resources. As a result, firms that are performing well
may not be able to acquire additional resources, even though
there are potentially large gains from trade.

To makes
matters worse, this curious dynamic plays itself out in a
way that makes recessionary troughs deeper while acting as
a drag on the potential of boom times to deliver even greater
returns, say Rampini and Eisfeldt.

"We're
trying to understand aggregate output over the business cycle,"
says Eisfeldt. "You have recessions where aggregate output
is low, and booms where aggregate output is high. Part of
what determines aggregate output is how resources are allocated
between people who can use them really well, and people who
can't use them well."

She and
Rampini have investigated the factors that they believe drive
this dynamic. Their findings point to managerial incentives
and draw upon the insights of agency theory, a way of thinking
about incentives in corporate teams. Agency theory considers
the relationships between shareholders (or principals) and
managers (their agents). The theory's central assumption is
that not everyone has the same goals or motivations, even
if they're on the same team—something the Kellogg School
researchers have validated and developed in their own theories.

"It's
puzzling. We see a lot of reallocation of capital during booms,
versus recessions. We see lots of mergers and acquisitions,
and sales of capital and equipment. We see the flow of capital
from low-productivity firms to high-productivity firms in
good times, when the benefits in terms of productivity differences
across firms are smaller, and not so much in bad times, when
the potential productivity gains are largest," says Eisfeldt.

"Our
question is: What is it that keeps capital from moving to
the highest productivity firms, in particular in bad times?"

"If
you have perfectly diversified the risk of your new venture,
the odds are that you won't succeed," says Prof. Andriano
Rampini.

Part of
the answer is that managers of less-productive firms are unwilling
or very slow to divulge negative information about the performance
of the assets under their control.

Managers
of low-productivity firms (or divisions within firms) will
know details about their under-performance long before that
information becomes public and can be acted on by stakeholders.
By the time this information makes the rounds, considerable
damage has already been done: opportunities to reallocate
with maximum effectiveness will have been lost, and costs
associated with the poor productivity will have already taken
a toll on the firm.

This
dynamic, played out over many firms, also influences the aggregate
market, contend Eisfeldt and Rampini. This fact makes the
implications of their research important for investigating
new capital reallocation strategies that minimize the fallout
from under-producing firms by encouraging this capital to
flow to the firms that can best utilize it.

The challenge
is to provide incentives for the low-productivity manager
to sell assets to the high-productivity manager, Rampini says.
It's difficult to get managers to reveal bad news early. "You've
got to give them something to motivate them to reveal this
information. If you don't do anything, they won't tell you,
because the outcome is only bad for them."

The incentive
typically involves cash. But here is where things get tricky.
Pay managers too much, and the incentive value disappears,
since managers may figure that they will be compensated handsomely
regardless of performance. Pay them too little, and they are
likely to conceal that all-important productivity information
essential to capital reallocation.

Most
people will be able to explain why you would pay managers
more when they do well and pay them less when they do poorly,
says Eisfeldt.

"That's
the standard way of thinking," she says. "Our idea
is going to have you paying managers when they do poorly.
That's hard to explain to some people. But if you don't pay
managers when they're doing poorly, they might know they're
doing poorly and not reveal it," resulting in even more
serious problems for the firm.